V.F. Corporation Blows Up Investment Thesis. Now What? (NYSE:VFC)

Introduction

For many years the investment thesis for V.F. Corporation (NYSE:VFC) was straightforward and simple. Based on its 49 year record of increasing dividends, income investors could count on gradually rising dividends for a steady income. Other investors could count on substantial support from the dividend to put a floor under the stock price and wait for capital gains over time as the company applied its deep expertise to navigate the ups and downs of the apparel sector. Then, on February 7, the company announced a 41% cut in the dividend from $2.04 to $1.20 per annum. This was a shock to many, including me, and requires rethinking the investment thesis from the ground up. This article will assess the investment case under the new circumstances and look at what investors in VFC can expect over the next several years.

A time tested winning strategy

One of my most successful investing strategies over decades has been buying companies that offer a yield near a record high compared to their yield history. The strategy starts with companies with the following characteristics:

• A long history of growing dividends

• Substantial ongoing business with staying power

• Substantial drop in share price due to macroeconomic, industry, or company specific conditions.

• Record yield is due to the share price drop

• Reasonable odds that the company will overcome adverse conditions, maintain the dividend, and return to growth in revenue, earnings, and stock price.

The end result of this strategy is high capital gains as the stock returns to normal levels, and an unusually large income from dividends as long as the stock is held.

I wrote a series of SA articles on the subject in 2017. The recommendations are now dated, of course, but the theory behind it is as valid as ever and worth a read. See, for example, Historically High Yields For The Dividend Investor.

The strategy was successful with companies like Lowe’s (LOW), Target (TGT), and Kroger (KR). Even when anticipated stock price gains didn’t materialize while I was a shareholder, the outsized yields meant an overall gain, as with Cardinal Health (CAH), Tanger (SKT), and Exxon Mobil (XOM). In no case did the poor outlook at the time result in an overall loss.

Adapting the strategy from the VFC experience

VFC seemed to be a good candidate for this strategy, based on its yield and price history. The two times in the past when the yield peaked were followed by substantial increases in the stock price.

Instead, VFC shows that this strategy doesn’t work if the yield is too far above the previous high. An extreme yield is a signal of extreme stress. In the case of VFC, the yield was far higher than its previous record. This turned out to be a sign of unusually high stress, and a time when the dividend finally could no longer be supported. Therefore, the investment case for VFC must be found elsewhere.

February 7: A very bad quarter

There’s only one way to describe the Q3 2023 report: bad. Some lowlights:

• Sales down from a year ago.
• Gross margins down
• Net margins down
• Adjusted cash flow of $700 million, down from an already reduced forecast of $900 million two months ago.
• Inventory 100% above normal
• Slower business over the next couple of quarters
• $874 million payment to the IRS from an adverse decision related to the Timberland acquisition in 2011.
• Long term debt double the level of three years ago.
• $442 million writedown on the Supreme acquisition.

There were a couple of positives.

• There has been a change in leadership, as described in detail below. Second, there were pockets of success including a 7% increase in North Face sales.
• Although global sales decreased 3%, they increased 3% in constant dollars (before foreign sales were converted to US dollars).
• The EMEA region had a seventh consecutive quarter of increased revenue in constant dollars.
• Supply chains are returning to normal, which means more accurate inventory buys and delivery, and not as much expensive air freight.

Why was Q3 so bad?

The company attributed much of its difficulties to the chaotic supply chain of the last three years, which completely upended the product cycle. There was a huge mismatch between when consumers wanted product and when VFC could deliver it, and now they have a huge amount of inventory at the wrong part of the product cycle. To be fair, everyone in the apparel industry has reported similar problems, but VFC managed it particularly badly. For example, Capri (CPRI), a company in SA’s VFC peer list, recently reported excess inventory levels of 26%, compared to VFCs 100%. This is especially galling for a company that has a long record of excellence in supply chain management.

The timing of certain financial events has exacerbated the situation. The Supreme acquisition may have been poorly conceived, but being finalized during the economic disruption of the pandemic made the impact worse. In addition, the $874 million IRS judgment added a billion dollar term loan added to the already high debt.

In the Q3 conference call the company also acknowledges subpar execution in its core competencies of marketing, innovation, and customer relationships. This was a “clear the decks” quarter for VFC. They laid bare the totality of their situation and identified precisely what must be done to turn things around.

The financial situation and response

This quarter continues trends seen throughout 2022. As indicated in the Q3 report, the balance sheet and cash flow are at the point of impairing the company’s ability to operate effectively. As a result, they are taking every possible measure to restore financial strength:

• Cutting the dividend 41% will save about $330 million annually.
• Cost cutting throughout the company will generate $225 million annually by end of 2024.
• Asset sales, including sale/leaseback of the international HQ building, will generate about $100 million
• Selling off non-core parts of the company, including JanSport, Eastpack, and Kipling brands.
• Suspending share buybacks.

VFC’s new outlook

The huge inventory overhang will take a couple of quarters to resolve, and will hurt sales and profits until then. Fortunately, they report that global supply chain nightmare is resolving itself. Although currency effects once again hurt gross margins for the quarter, it was reported that during the quarter currencies finally turned from headwind to tailwind. In addition, the China market is finally reopening. China was relatively small for VFC but a significant piece of their future growth plan before the pandemic upended it.

The financial steps listed above will generate $200 million in new cash and about $900 million in savings over two years. This, along with better cash flows, can be used to attack the debt, which stands at $4.6 billion. The company carried $2.1 billion in debt in 2019.

At the same time, the company will be re-allocating resources to the areas with the highest profit potential, meaning flagship brands North Face, Vans, and Timberland. For example, product development investment as a percentage of revenue for Vans, their biggest brand, lags well behind the company average. This will change. VFC will also focus on the unrealized potential recent acquisition Supreme and other promising brands like Altra.

Although some of the reasons behind VFC’s troubles were beyond their control, the Q3 report acknowledges responsibility for the subpar performance under the previous management. They see the present as a time for a thorough company reset — a time to re-establish the excellence that earned them prominence in their industry. This reset begins with Benno Dorer, the new interim CEO, who is discussed in more detail below. Dorer initiated the reset process when, as lead director, he saw the need to move beyond the previous CEO who had presided over the recent decline.

The investment case now

In the Q3 report, the company stated the intention of reducing the 4.5x leverage ratio to about 2.5x, signaling that debt reduction is a priority. They also said that they would consider increases in dividend when the payout ratio reached about 50%, down from the current high 50’s, and anticipated FY2025 as a possible time frame. Seeking Alpha shows 2024 earnings estimates at $2.26. 50% of that is $1.13, still less than the current $1.20 dividend. Beyond this, the company gave few specific financial forecasts, which was a responsible stance to take considering the circumstances. Given the many changes in finances, operations, and strategy, the timeline of future financial performance is too unclear. An investment case based on financial projections is not practical at this point in time.

Historically, as shown below, VFC’s stock price has closely reflected earnings, and although we don’t have good earnings estimates past Q4 we can assume the stock price will reflect any earnings improvement.

An assessment of the company’s future begins with the new interim president, Benno Dorer. who was the lead independent director until two months ago. Dorer, 58, had previously been CEO of Clorox (CLX), another global, diversified, consumer facing company, from 2014 to 2020. During his tenure Clorox revenue rose 22%, the dividend rose 49%, and earnings per share rose 68%. (Admittedly, CLX was a big beneficiary of the pandemic.) If anyone has the qualifications to lead VFC back to prominence, it’s him. Lest the “interim” title give anyone pause, Bob Iger gave a two year commitment to Disney (DIS) when he returned there recently to widespread acclaim. Dorer will not give up the reins at VFC until he is confident that the direction he imparts to the company is solidly grounded.

Investors are looking at a two year time frame before improvements in VFC lead to durable improvements in the stock price. The task ahead is huge: reduce massive debt, improve cash flow, repair customer relationships, and return to excellence in the apparel sector. The first issue, debt, will reduce the resources available to address the third and fourth. But VFC’s brands have enduring value, and VFC has the potential to turn their newer brands into big winners. This is not to say the stock price can’t bump upwards before two years. A single very good quarter on sales would be enough to reverse negative sentiment and send the stock up, but in the long run fundamentals still rule.

One factor on the minds of all VFC management and observers is the possibility of a recession. Leading Economic Indicators, the yield curve, the unemployment level and every other reliable indicator says we will have a recession sometime this year or next. A recession would have an adverse effect on revenues, profits, and stock price, and delay the company’s recovery.

A BUY rating

I give VFC a BUY rating under specific conditions. Investors must be willing to use a two year time frame for results, and find the 8.8% from two years of dividends an acceptable return in the interim. Concerning capital gains, the current forward PE ratio is 13.27, about half of the long term PE of about 25. The “E” has been declining, but the “P” has been dropping faster. If/when the business returns to previous performance levels, a return to a 25 PE would mean a gain of around 50%.

Investors must also believe in the company’s ability to return to its long term level of business performance. There is evidence that this is achievable, based on the company’s history, continued growth in certain parts of the business, and the changes outlined in the Q3 conference call.

Summing up

After VF Corporation’s dividend cut, the old investment thesis for this near Dividend King had to be discarded, and a new one established. VFC is at its lowest point financially in many years, and the stock price reflects that. A bet on VFC is a bet that current conditions are temporary and that the company will return to its former success. If there is truth to the saying, “be greedy when others are fearful,” then now is the time to invest. The best investing gains can come from buying a stock when the market is most pessimistic and shares are beaten down.

The potential for a rebound in the company and the stock is there, but investors must have patience. VFC can start today returning to excellence in marketing, innovation, and efficiency, but the debt situation is severe and will take a couple of years to repair. The company reports that it will be at least two years before the bottom line improves enough to consider an increase in the dividend. VFC is appropriate for investors who can wait and believe that the company can return to it’s long term record of success.